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Brexit Becomes A Reality

Brexit Becomes a Reality

In a surprise which has so far shocked global capital markets, a referendum in the United Kingdom resulted in a vote to leave the European Union (EU). This follows a week where markets had climbed to near peak levels as official polls and betting odds both appeared to indicate that the vote would favor staying in the EU. With the surprise, most markets globally are selling off indiscriminately without regard to the fundamentals of companies. While this clearly is a market moving event, it could present hidden opportunity for patient long-term investors.

 What is the European Union?

In a fast moving market, it is always best to start with the facts, and for those of us on this side of the pond, that starts with defining the European Union (EU). The EU consists of 28 member states which have ceded some political and economic control to the block in order to break down trade and immigration barriers between members as well as to negotiate with the rest of the world as a single, powerful economic block. The EU has its roots in the aftermath of World War II, where the original members saw economic and political coordination as a way to unify Europe and overcome much of the dangerous brand of nationalism prevalent at the time. The EU started with six core countries, and over the years various countries saw the benefits of being a member and joined the group. The United Kingdom joined the predecessor organization in 1973.

The majority of member states are also members of the Eurozone, a subset of EU members which use the Euro as their common currency. Notably, the United Kingdom had opted out of using the euro and had continued using the British pound as their currency. Most members of the EU had also signed on to the Schengen Agreement which opened borders between member states and abolished border controls. Again, the United Kingdom opted out of the agreement. The main benefit of EU membership is the ability to trade amongst member countries without the imposition of tariffs, as well as to be able to negotiate with the rest of the world as a powerful economic block.

Why did the United Kingdom Leave?

The vote to leave was driven by a desire to bring much of the control ceded to various institutions of the EU back to control by the United Kingdom. Within this broader concept are various political points of contention, many of which are valid, and many of which were exaggerated politics. For example, the Leave camp had highlighted how the open borders of the EU would be a security risk to the UK, particularly with the influx of refugees from Syria and other conflict zones in the Middle East. That argument resonated with many voters, despite the fact that it relied on a significant exaggeration as the United Kingdom, as stated above, had opted out of the Schengen Agreement and continued to have control of immigration policy.

Another significant Leave issue is the idea that the membership was too expensive on a net basis, with the UK sending billions to Brussels and not getting that much in return. This was, of course, an issue ripe for politics as there is no direct accounting between the payment for membership and the indirect benefit derived from that membership. For example, how do you quantify the fact that London has become the de facto financial capital of Europe? If you count all the benefits, then EU membership makes sense. If you don’t credit for all the impacts, then it is easy to simply focus on the outgoing dollars (pounds) and make the argument (which won) that membership does not have its privileges.

Finally, a big reason why the vote may have passed is the idea that the benefits to the country have not necessarily accrued to the individual voter. Consider, for example, British fishermen who have had to operate under quotas set in Brussels. To such a voter, the fate of bankers in London and the need to protect the financial sector by remaining a member likely did not resonate as much as an argument that leaving the EU could potentially mean a liberalization of fishing quotas.

It seems the EU has become a victim of its own sprawling bureaucracy. With so many rules, opt outs, side deals and more that the vote to exit carried by a narrow margin – 52% Leave to 48% Stay.

What Happens Now?

The immediate answer is – nothing. The vote is akin to filing for divorce. Both parties have been put on notice, and now the work begins to work on the separation agreement en route to a final divorce decree. This is not the first time a country has left, as Greenland voted to leave the block in 1982.1 However, the size of the UK economy means the exit is effectively unprecedented.

The terms of the EU agreement provide for a two year window to draft the separation agreement. The Leave camp had campaigned on a platform of getting better net trade deals. However, the EU has incentive to structure a poor deal for the UK in order to limit the incentive for other member states to consider a similar vote – they need to set an example. At the same time, they cannot structure such a poor deal as to negatively impact their own prospects for trade. This means there will be continued uncertainty as the remaining EU block fights for survival while the UK fights for economic independence.

In reality, there may not be that much that changes. In order to export to the EU, British manufacturers are going to have to abide by EU manufacturing requirements. At the same time, this creates uncertainty for multinational corporations with plant and equipment in multiple EU countries and the UK. What tariffs will apply? Will a free flow of capital still be available? The UK is still dependent on skilled immigration for growth, how will that change?

What Does This Mean for My Portfolio?

In the immediate aftermath, global markets have sold off, but are well off their low points. The U.S. 10- year treasury rate had dipped as low as 1.42% overnight in a flight to safety, but has since traded back to 1.57%, roughly where it stood about a week ago.2 Most sovereign debt is trading with lower interest rates as investors seek the perceived safety of global government bonds. U.S. equity markets were off more than 5% in pre-market trading, but have since traded back to roughly 2.5% losses.3 The British pound has traded off by more than 10% overnight, and has since recovered to roughly a 5% loss. As would be expected, European markets are generally off around 5%, with more significant losses in countries which are seen as the next potential candidates to consider an exit – France, Italy and Spain. Notably, U.S. markets remain within approximately 3% of all-time highs.

1 “If it were done,” The Economist, June 4th 2016 2 FactSet 3 FactSet intraday pricing.

Markets are likely to remain volatile as investors get over the immediate shock of the Leave camp winning and get to the business of analyzing what it means for company fundamentals and the global economy. In that indiscriminate selling lies some opportunity for investors. Various international managers have commented that a Brexit could put some companies which are expected to experience a limited impact on sale. In short, any substantial economic event like this is going to create winners and losers. For example, banks based in the EU may benefit from a lesser importance of London based banks, providing an opportunity to expand and grow earnings. Working with an active manager to find these opportunities could serve to limit risk and rotate into companies which could benefit from the changes. And while this creates temporary disruption, this does not stymie the march of innovation and overall consumption of goods and services.

Disclosures: Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses. Your individual allocation may be different than the HDVAS sample strategic model due to your unique individual circumstances. An investment cannot be made directly into an index Investments are subject to market risks including the potential loss of principal invested. Specific investments mentioned are hypothetical and are not a recommendation to take any action with respect to those specific securities. The information presented is not an offer to buy or sell, or a solicitation of an offer to buy or sell the securities or strategies mentioned. The investments discussed or recommended in the presentation may be unsuitable for some investors depending on their specific investment objectives and financial position. Investors should consult with their Advisor regarding their specific situation. The Standard and Poor’s 500 is a capitalization weighted index of 500 leading companies in leading industries of the U.S. economy. It covers approximately 75% of the total capitalization of U.S. equities The Barclays U.S. Aggregate Bond index measures the performance of investment grade bonds in the U.S. fixed income universe. It includes U.S Treasury issues, agency issues, corporate bond issues and mortgage-backed issues. It is unmanaged, includes reinvestment of dividends, does not reflect the impact of transaction, manager or performance fees and is unavailable for investment. Unless otherwise indicated, all mutual fund and index performance data throughout report – © 2016 Morningstar, Inc. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar not its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.

As always, the best way to limit the pain of a downturn is to understand what the downturn means for your financial goals. Ten years from now, new trade agreements will be in place, and if the Leave camp was right, the UK will be experiencing faster economic growth than if it had stayed in the EU. While such a projection is necessarily uncertain, history is filled with episodes of temporary setbacks, a rotation of resources and relationships, and a re-emergence of growth. We believe the best way to mitigate the impact of such events is to stay disciplined through these periods by maintaining an appropriate allocation which is rebalanced periodically to reset your risk. If the current market volatility has you concerned, we advise talking to your HD Vest Advisory Representative to discuss your concerns and to build a financial plan